The Next Buyout Stock

Think like a private equity investor, but think for yourself.

After a torrid first half of 2007, in which announced leveraged buyouts (LBOs) totaled $616 billion, the pace of buyouts came to a halt in August. The trend bogged down amid concerns that investment banks wouldn't be able to sell on the $300 billion to $350 billion backlog of leveraged loans they had taken on to finance the transactions. (The remaining backlog is currently at around $190 billion).

September was to be the month of reckoning, as investors waited for the outcome of planned debt sales on some megadeals. So far, private equity firms and banks have mostly played nice in order to get the deals done -- renegotiating loan covenants and/or raising the interest rate on the loans. The bellwether buyouts of TXU and First Data have been completed, but some deals have fallen through. ValueAct Capital Partners and Silver Lake Partners walked away from the acquisition of Acxiom (NASDAQ:ACXM), paying the firm $65 million for its trouble.

In some cases, proceedings have taken a harder turn. Sallie Mae (NYSE:SLM) recently filed a lawsuit against the buyout consortium of J.C. Flowers & Co. and the investment arms of Bank of America (NYSE:BAC) and JPMorgan Chase (NYSE:JPM). The consortium originally offered to take Sallie Mae private at $60 per share; the student lender now wants them to honor the agreement at the original terms or pay the $900 million "breakup fee."

I now expect buyout activity to resume next year, albeit at a slower pace than in the first half and with fewer mega-cap targets. LBO firms are still flush with cash that needs to find a home. (Dow Jones Private Equity Analyst estimates that LBO and corporate finance shops raised $108 billion in the first half of this year alone!) Naturally, many investors are curious to know which company will be snatched up by private equity investors. If I wanted to sleuth the public markets in search of the next buyout target, I'd take a step back and ask myself the following question:

What types of companies do private equity firms tend to invest in?

These are four primary characteristics of firms that private equity firms target:

Steady and predictable cash flowsLBOs -- the "L" stands for "leveraged" -- are financed by large amounts of debt. Investors look for companies that will be able to make the associated interest payments by generating healthy, steady cash flows from their operations.

Clean balance sheet with little debtDebt boosts the returns of private equity investor returns in an LBO. If a company already has a lot of debt on its balance sheet, it's not a viable candidate.

Strong, defensible market positionNo surprise here! A defensible market position is attractive for a couple of reasons: First, it is a key determinant of a firm's ability to generate steady cash flows year in, year out. Second, firms with a defensible competitive position are those that are most likely to compound their intrinsic value. Increases in intrinsic value are another source of LBO investor returns.

Minimum future capital requirementsCapital expenditures required to maintain the firm's operations consume cash flow from operations that could otherwise be allocated to other uses. In a company that has been taken private through an LBO, the priority is the payment of interest or principal payments on the new debt. All other things equal, companies with low maintenance capital expenditures can dedicate more cash to servicing their debt.

Do these four criteria sound familiar? If, like me, you're a value investor, they might as well be a mantra. That's not a coincidence: Value investors believe in adopting the mindset of a control investor -- we approach every stock purchase as if we were acquiring the entire company, and these are the hallmarks of superior companies. Stocks represent ownership interests in businesses -- a quaint notion, sure, but one value investors still favor.

My "Potential Buy-Out" screenTo try to find potential buyout candidates, I created a stock screen based on criteria that try to capture the characteristics I discussed above. These are the criteria I used:

Free-cash-flow margin greater than 15% over the trailing 12 months, and for the years 2004 through 2006.

Total debt-to-capital ratio less than 20%.

Capital expenditures to revenues less than 8%.

No investors worth their salt want to overpay -- even for a high-quality company -- so I added a valuation criteria:

Enterprise value-to-EBITDA less than 11 [EV/ EBITDA is a valuation ratio widely used by LBO investors].

Here are two companies that showed up in my screen:

Industry

TTM FCF Margin

Return on Capital

EV/ EBITDA

DreamWorks Animation (NYSE:DWA)

Movie production

90%

14%

10.6

PMI Group (NYSE:PMI)

Surety and title insurance

48%

8%

3.4

These aren't recommendations, but they might be worthy of further investigation.

Don't bet on buyoutsAs an individual investor, you shouldn't be buying stocks purely in the hope that they'll get bought out. While you'll get a nice short-term gain, you're also leaving future gains on the table. Remember: Private equity will buy out a company only if it thinks it can get gains far in excess of the buyout price.

So instead of trying to guess where private equity will be stepping next -- an approach that is unlikely to prove financially rewarding -- focus on finding outstanding companies trading at bargain prices. That's what we do at our Inside Value service. You can take a look at all of our research and value recommendations by clicking here to join Inside Value free for 30 days.

After all, if you find enough outstanding companies trading on the cheap, private equity will find you.

Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. Bank of America and JPMorgan Chase are Motley Fool Income Investor picks. DreamWorks Animation is a Stock Advisor recommendation. The Motley Fool has a disclosure policy.